Stock Options: Now You Care?

It seems that when investors were getting wealthy by holding stocks of almost any flavor stock options grants were of little concern. Now that the stock market has turned sour, investors are no longer very patient with insiders getting multi-million dollar stock options grants. Well, it's about time. The Motley Fool has been howling about this for several years.

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By Bill Mann (TMF Otter)
April 2, 2002

Crickets chirped. Somewhere in the distance, a dog barked. We could distinctly hear the sound of one hand clapping.

I am speaking, of course, of the response The Motley Fool received when we covered the dangers of heavy stock option overhang back in 1999.

No one cared. We might as well had written a treatise on the effect on surfactants in oxygen-free environments. In Bulgarian.

In the wake of the high profile collapses of Enron and Global Crossing -- collapses that were somewhat cushioned for company executives by virtue of their having cashed in millions of shares of stock worth in both cases in excess of a billion dollars -- suddenly executive compensation is a big deal. We feel the pain, and we want the bozos and (in some case) criminals who ran these companies to be financially hurting as well. But back when everyone was getting rich in the stock market, no one cared. The board gave Steve Jobs a stock option grant worth several hundred million dollars? Whoopdeedoo. Have you seen Apple's (Nasdaq: AAPL) stock price this year?

Some of our content from 1999 had titles like "Options Overhang," "Options Overhang II: The Real Deal," "The Trouble With Options," "Should Management Profit from Screwing Up?" "Optionmania!," "Optionmania II: Impact," "Optionmania III: Takedown," "What Are the Options," and "T. Rowe's Matador Management" (trust me, it's about options). All of these pieces poked at something that three years later people are kind of fired up about: stock option mega-grants to employees and their negative impact on outside shareholders.

There are a few reasons that I'm bringing up this long-standing focus we've had on stock options. First of all, I'd like to re-recognize some of the outstanding work some of these writers did on the subject. Alex Schay, Louis Corrigan, and Warren Gump expended significant effort on an issue that was important, but not exactly in the forefront. Yeah, there's a screed or two from me there as well. Standing on the backs of giants, and all that.

These guys were taking cues from some of the biggest proponents of good corporate governance: Warren Buffett, the hyper-rich, chronically underpaid chairman of Berkshire Hathaway (NYSE: BRK.A), Ken Bertsch, the head of corporate governance at TIAA-CREF, and Philip Fisher, the author of Common Stocks, Uncommon Profits, among them. Ah, and then there was the good old Economist, stiff upper lip and all, standing on the other side of the Atlantic, watching the massive stock options grants being given among American corporations and saying, in its own haughty way: "What the hell are you people thinking?"

I'm also bringing these stories up to do a little horn-tooting. You cannot open a financial publication today without one of the lead stories being the atrocious sums of money that executives are paying themselves for their jobs. The Washington Post, The New York TimesThe Wall Street Journal, you name it -- they're now on stock options like the stink on old cheese. Last week, USA Today put together a list of 100 companies and listed the amount of compensation and options their chief executives received. Apparently, according to the big journals, executives have paid themselves obscene amounts of stock options, which are awfully convenient forms of compensation in that the corporations do not have to account for them.

And finally, we should discuss the past Foolish coverage of stock options to sound a warning: Too many times investors have treated certain risks as being fake or mythical simply because they had not been hurt by them yet. Were the telecom companies really hurt by the collapsing market in 2000-2001, when their stocks actually dropped, or was that the end result of their collective poor capital allocation decisions and massive debt build up from the 1990s? Did Enron "happen" in 2001, or was that the culmination of years of shenanigans? Bingo. We didn't care about stock options in 1999 because, well, individual investors were doing GREAT. Why worry about that stuff? The buffet table is loaded, so what if some are taking home doggie bags?

Well, we care now, because outside investors have lost big bucks, rank-and-file employees have seen their retirement funds decimated, and Gary Winnick (of Global Crossing fame) cashed in more than $700 million in stock while his company collapsed. The Prozac market has finally come unglued, and we suddenly feel that those who run companies ought to have their financial fortunes actually tied to that of the companies they run. Options aren't working. If they were, Rich McGinn, who ran Lucent (NYSE: LU) into the ground with capital deployment decisions that ultimately nearly destroyed the company, would be broke. Guess who's not broke?

Ken Chenault presided over an American Express (NYSE: AXP) that lost more than $1 billion in equity in 2001 due to poor investment decisions at the company and his pay package doubled to $14 million, the majority in incentive stock options. What kind of incentive goes along with losing a billion dollars?!

Chenault and American Express are by no means the worst offenders. AOL Time Warner (NYSE: AOL) granted both Steve Case and Gerald Levin $70 million plus stock options packages in 2001. The average American company currently has set aside more than 15% of its total share float to give to employees in the form of options, and these are never accounted for. Brocade's (Nasdaq: BRCD) stock options program is larcenous. Oracle's (Nasdaq: ORCL) is ridiculous. Yahoo! (Nasdaq: YHOO) gave out outrageous numbers of options over the past few years, but then because the stock price dropped, cancelled them to issue new ones. Hellooooooo? I thought options were supposed to be incentives, not entitlements.

We're paying attention now because suddenly we're seeing that stock options abuse has created a system where executives win no matter what. Two weeks ago, The New York Times ran a story in which corporate spokespeople pointed to a study stating that accounting for stock options "would have reduced operating earnings by 40 percent in 2000." This single sentence fragment points to just how stupid they think we are. The stock options did reduce operating earnings by that much, companies just weren't required to tell us about it. A lack of accounting for them doesn't make the effect any less real. Companies granting 4, 5, 6 percent or more of their shares each year are committing daylight robbery of their shareholders.

And spare me the "aligning shareholder and employee interests" garbage. It's a waste of breath. Options are abused now because the cost of them appears to be zero. Pay your executives, pay 'em really, really well. But pay 'em in cash and let them buy stock on the open market. Then they'll be shareholders, enjoying the benefit of their labors and suffering the pain of their failures. As we stand today, this is just not the case. Our friends at Enron and Global Crossing may have finally crossed the line, so this is a gravy train that may have finally derailed, because too many people have finally noticed.

I wish I were surprised, but I'm too busy wondering where all those crickets went.

Bill Mann is Senior Editor for The Motley Fool. At time of publishing, Bill owned shares in Berkshire Hathaway and American Express. The Motley Fool has a disclosure policy.